Tracking the 52 Week High: Does Trend Following Work for Stocks?

Stockopedia

Jul. 19, 2011, 3:19 AM

In Brief

An investing screen based on buying stocks that are close to their 52 week high (and/or selling stocks that are close to their 52 week lows), particularly in industries whose stock prices are close to their 52 week highs (or lows). Similar to other forms of momentum investing, this appears to work because investors tend to under-react to positive (or negative) information about those kinds of stocks.

Background

Every day, financials newspapers like the Wall Street Journal, the Financial Times, and the South China Morning Post publish lists of stocks whose prices have attained new 52-week highs and lows. Many investors approach such a list with trepidation, understandably assuming that this may mean that stocks prices are approaching "nosebleed" territory. However, recent research suggests that this may be exactly the wrong conclusion, perhaps precisely because everyone else is thinking the same thing. As has been discussed elsewhere, academic researchers have found that stock prices look to have quot;momentumquot;. More recently, work by researchers George and Hwang published in the Journal of Finance has shown that the closer a stock's current price is to its 52-week high, the stronger that stock's performance in the subsequent period. They conclude that "price levels are more important determinants of momentum effects than are past price changes". In subsequent work this year, they also found an industry level 52 week high effect which was even more pronounced.

Why Does it Work?

George and Hwang surmise that investors use the 52- week high as an "anchor" against which they value stocks, thus they tend to be reluctant to buy a stock as it nears this point regardless of new positive information. As a result, investors underreact when stock prices approach the 52-week high, and consequently, contrary to most investors' expectations, stocks near their 52-week highs tend to be systematically undervalued. Finally, when information prevails and the 52 week high is broken, the market "wakes up" and prices see excess gains. Similarly, when bad news pushes a stock's price far from its 52-Week High, traders are initially unwilling to sell the stock at prices that are as low as the information implies.

They conclude:

"Traders' reluctance to revise their priors is price-level dependent. The greatest reluctance is at pricelevels nearest and farthest from the stock's 52-week high. At prices that are neither near nor far from the 52-week high, priors adjust more quickly and there is no pronounced predictability when information arrives".

Screen Criteria

The underlying idea is that long positions are taken in stocks whose current price is close to the 52-week high, so some indicative criteria might be:

Volume above bottom 20% of the database

Market Capitalisation above bottom 20% of the database

Proximity of stock to 52W high is within the top 30% of the database (an quot;individual stock 52-week highquot; strategy).

Or alternatively:

Proximity of stock's industry to its 52W high is within the top 30% of the database (an quot;industry 52-week highquot; strategy).

Stocks are assumed to be held for 6 months and then recycled.

How well does it work?

The original research found that, between 1963 - 2001, the average monthly gain to this strategy assuming a 6 month hold was 0.45% - " about twice as large as those associated with other momentum strategies". Returns were also very persistent. Work by JP Morgan came to similar conclusions about the effectiveness of the strategy.

quot;a strategy that buys stocks in industries in which stock prices are close to 52-week highs and shorts stocks in industries in which stock prices are far from 52-week highs generates a monthly return of 0.60% from 1963 to 2009, roughly 50% higher than the profit from the individual 52-week high strategy in the same periodquot;.

This was then boosted to 0.78% monthly if stocks were held for three months only.

The academic research was done using a combined long/short strategy. However, the latest paper confirms that investor underreaction to positive news accounted for more of the profits than investor underreaction to negative news, suggesting it may be reasonable to implement the strategy on a long-only basis.

Geek Stuff

Firstly, as is the case with other momentum strategies, the researchers found that the return to the quot; individual stock 52-week highquot; strategy is actually negative in January (apparently because loser stocks tend to rebound in January). Interestingly, though, the quot;industry level 52 week highquot; strategy did not have this characteristic. Secondly, the more recent industry level work also indicates that the 52-week high effect is mainly driven by investor underreaction to industry, instead of firm-specific, information. Even the quot;individual 52-week high strategyquot; seems to work best among stocks with high R-squares and high industry betas (i.e. stocks whose values are more affected by industry factors).